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Short sales have become a critical alternative to foreclosure for struggling homeowners who are underwater.

However, a decision by the Assembly Appropriations Committee within the California legislature is about to make this option much less appealing for troubled borrowers.

Failure to move Senate Bill 30 out of the appropriations committee in California means homeowners who sold their homes in a short sale over the past eight months will be forced to pay state income taxes on money they never received, the California Association of Realtors warned in a report.

Senate Bill 30, backed by C.A.R., conforms California tax law to federal tax law, which states that sellers cannot be taxed on forgiven debt. Without it, troubled borrowers wanting a short sale are stuck between a rock and a hard place, C.A.R. claims.

"We are disappointed that California Assemblyman Mike Gatto (D-Pasadena) failed to show the leadership necessary to provide relief to distressed homeowners who are already in dire financial trouble," said C.A.R. President Don Faught.

He added, "These are real families in real financial need who may well be forced into bankruptcy by an unresponsive legislature."

Under the current law, when a lender forgives mortgage debt in a short sale, the seller must pay state income tax on the amount of debt forgiven.

The previous California exemption to this rule lapsed at the end of 2012, so forgiven mortgage debt on short sales is now considered taxable state income.

"It’s a little surprising that the bill hasn’t gained more momentum given the administration and assembly's enthusiasm for homeowner relief as clearly evidence by the California Homeowner Bill of Rights, which is almost by definition the most extreme servicing regulatory action we’ve seen anywhere in the country," explained Auction.com executive vice president Rick Sharga.

He added, "It’s certainly not good news for homeowners who now may be disinclined to participate in short sales."

Sharga said he fears the California market could see a shift in attitudes when it comes to the effectiveness of short sales, with lenders willing to pursue them while borrowers opt out.

"Short sales help the housing market recover from the downturn more than foreclosures do because it’s a better outcome for all parties involved," Sharga stated.

Since the legislature has not passed the proposal during this session, there’s still unfinished business that will impact the taxpayers who sold their homes in a short sale.

"If the bill ultimately doesn't pass, families that were forced to sell their home in a short sale will be forced to pay state income tax on money they’ve never actually received," Faught warned.

He added, "We hope that that the legislature will rectify this in the closing days of the session."

Christina Mlynski is a Reporter at HousingWire. She graduated with a bachelor's degree in news/editorial journalism from the University of North Texas, and previously worked for publications such as the Dallas Business Journal and Dallas Observer.

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